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In a Q&A with AR, the former Paloma Partners executive, now a professor of business, continues to worry about hedge fund risk.

Leon Metzger in January 2009 speaking at a House
Financial Services Committee hearing on the Madoff
Ponzi scheme.

Source: Bloomberg News

Leon Metzger left a high-powered job as vice chairman and
chief administrative officer of Paloma Partners in 2006 to
become a part-time faculty member at various business schools
where he teaches graduate-level classes about how the hedge
fund industry operates.

After 18 years at then-$1.6 billion Paloma in Greenwich, Conn., he left amid a sweeping reorganization designed to boost
flagging returns following $600 million of redemptions during
the previous six months. Metzger continues to hold a legacy
investment in Paloma Partners, which now manages $1.9 billion,
but he does not hold any positions in other hedge funds.

Instead of retiring, Metzger, who earned degrees
from The Wharton School of the University of Pennsylvania and
Harvard Business School, became a teacher, serving as an adjunct professor
at Yale and at NYU’s Stern School of
Business. He has also lectured at Columbia
University’s Fu Foundation School of Engineering
and at Cornell University’s financial engineering program in Manhattan.

In addition to his teaching the next generation of
investors, Meltzer has lectured the U.S. House Financial
Services Committee about financial oversight, urging the hedge
fund industry to get serious about risk management. This week,
he delivered a speech at an alternative investment conference
in New York titled "What will hedge funds not tell you?"

In a telephone interview, the 56 year old spoke to
AR about his life as an academic and his
views on the hedge fund industry:

AR:You went from holding a top position at a
prestigious hedge fund to being an adjunct professor working
semester-to-semester in contract positions. Do you feel like
you’ve taken a step down?

Leon Metzger: I tell my
students I run the classroom like a hedge
fund­—the only exception is that expletives are
not allowed in the classroom. And obviously no harassment is
allowed in the classroom, either.

Particularly in times of crises, the students treat
you with respect. During the week this summer when stocks were
all over the place, I was teaching in Tel Aviv. We threw out
all of the course materials and just asked "What would we
do?"

We talked specifically about whether gold was
overpriced, then at $1,800 per ounce. Even if it were, it could
still rise to, say, $2,200 before any eventual decline.
Nevertheless, it could be expensive to hold on to a short
position even if, ultimately, the asset is overpriced. Someone
who is convinced that gold is overpriced might still avoid
shorting it.

Another question was whether or not it was a good
idea to be short the two-year Treasury, given that at some
point interest rates should rise, and if interest rates rise
while you are short the note, its value should decline.

AR: What has changed
for you over the past five years?

Leon Metzger: I’ve
watched student interest in the course (on hedge fund
management) go up and down and back up again, consistent with
the economy. Post-2008, I saw a decreased interest and I think
it’s going back up again.

AR:In the wake of the high-profile role some
hedge funds played in the financial crisis, have you seen
students come in with different perspectives or more
skepticism?

Leon Metzger: All my
students are more knowledgeable in particular about operations.
When I first started teaching the course in 2006, all they
wanted to know was how to make investments. Today, they are
much more interested in operations. But for many investors, due
diligence still too often stops and starts with past
performance record.

AR: You recently
gave a speech titled "What will hedge funds not tell you?" What
are some things you think investors don’t
realize?

Leon Metzger: I question
whether volatility, also known as standard deviation, is the
appropriate measure for risk in these hedge funds strategies.
It’s industry practice, but there are a lot of
things that are industry practice that I don’t
believe in. Modern portfolio theory says standard deviation is
the correct measure, but that should not apply when the payoff
is a high probability of a small profit and a low probability
of an extreme loss. A fund’s track record may hide
its risk.

I teach my students not how to make money, but how
not to lose it because of weak controls. Just because someone
was a wildly successful trader on Wall Street and decides to
launch a hedge fund does not mean he will be successful.

AR: What else
would you tell investors?

Leon Metzger: Size is the
enemy of performance. Investors who want to maximize their
returns should start their search by looking for younger funds
and smaller funds. Less capital should be easier to manage than
more capital. Emerging managers are more aggressive because
they haven’t reached the stage yet where they have
to preserve their own capital.

AR: How do you
reconcile that with your experience at Paloma, which managed
$1.6 billion when you departed?

Leon Metzger: Paloma was
known for investing with smaller managers early in their
lifecycles—for example, putting its money with
managers such as David Shaw, Dan Arbess, and Amaranth. And they
took it out of Amaranth when they thought it got too big.

AR: Besides Paloma, what
else are you invested in?

Leon Metzger:
I’d rather not talk about my own investments.
I’m not an investment advisor.

AR: You have testified
for Congress that operational risk is "the great unspoken-about
danger." What do you think are the biggest operational risks
for hedge funds today?

Leon Metzger: If you had
asked me in 2006 I would have said risk management after
Amaranth imploded. From 2002 to 2004 it was valuations­.
That was the big thing. After 2008, it became liquidity. To me,
valuations are the biggest risk today. If you have the wrong
valuations, your risk management could be wrong.

Are the valuations being done by an independent and
sophisticated knowledgeable party or are they being done by a
trader whose compensation is being based on the valuation of
the books?

Investors should be given enough information so
they can assess the risk in their portfolio. What really
matters is not the data but the judgment of those in power to
make decisions based on the data.

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